Download surety bonds: booming but misunderstood

FEATURE / SURETY BONDS
IBAMAG.COM
December 2015
SURETY BONDS:
BOOMING BUT MISUNDERSTOOD
Ages-old surety pervades modern society, but the average
person’s understanding of it is still stuck in the dark ages.
Surety has been around since the dawn of
human commerce, back when contracts
were literally written in stone.
Historians have sleuthed out evidence of
individual surety bonds in the legendary
Code of Hammurabi. (A well-preserved
Babylonian law code, chiseled into a
2.3-meter-high stone column dating to
about 1754 BC.) They’ve also found evidence of surety bonds in Persia, Assyria,
Rome and Carthage; among the ancient
Hebrews; and (much later) in England.
Surety is just as pervasive in our world
today. It finds its expression through a
vast array of surety bonds – legally binding
mechanisms that financially guarantee the
performance of an individual or a business.
Surety bonds represent $5 billion worth of
premium annually. The average person’s
understanding of surety, however – and
how it fits into the wider world of insurance
– seems stuck in the dark ages.
Perhaps that’s because surety bonds
are unique – part insurance, part financial
product – with an intense underwriting
process that sets them apart from the
rest of the insurance industry.
“Surety represents a small portion of the
overall insurance world that not many
people know about, and we’re okay with
that,” says Bill Krumm, who heads up Arthur
J. Gallagher & Co.’s national commercial
surety practice. But as more public entities
and private companies require guarantees
that products will be delivered and services
will be performed, “Being bonded can mean
the difference between being invited to bid
on a contract and readying about the award
in the newspaper,” Krumm says.
How bonding works
A surety bond is essentially a third-party
guarantee.
A three-way agreement between a principal– a person or entity required to post
bond; an obligee – a government entity or
person requiring principal to be bonded;
and a surety– provides financial guarantee
to obligee on behalf of principal person of
the surety company.
Surety bonds come in two major categories: contract and commercial. Most
premium in the surety market is in the
contract surety area – “sticks & bricks”
and heavy-construction projects such as
highways, bridges, dams, dredging, public
infrastructure, schools, local parks and
recreation.
The federal government (under the Miller
Act) and most states mandate that publicly
funded projects over a threshold dollar
value – which varies from state to state – must
include some form of “guarantee” protecting
the public’s interest.
“This guarantee, usually a contract bond,
assures that the selected contractor and
its team of subcontractors and suppliers
will complete the project as specified – on
time, on budget and without lien,” explains
Krumm. “Surety isn’t just for publicly funded projects. We’re seeing sophisticated
private owners require bonds to protect
their construction projects.”
Some of the most common forms of
contract bonds are:
•Bid bonds, requiring contractors to enter
into the contract if their bid for a project
is chosen and allowing the project developer to recover the difference between
that bid and the next-lowest bid if a
contractor refuses to accept the contract.
•Performance bonds, providing project
owners and developers with financial
protection in the event that a contractor
doesn’t finish the project according
to contract.
•Payment bonds, ensuring that contrac-
tors will pay subcontractors, suppliers
and laborers as outlined in the contract.
Other miscellaneous bonds commonly
written to support the construction
industry include wage and welfare bonds,
license and permit bonds, highway and
roadway access bonds, and various
preservation bonds.
Commercial surety bonds, meanwhile,
are generally required by state laws
and statutes rather than by contract,
and guarantee some aspect of a
principal’s occupation.
“They’re used to regulate markets and
keep working professionals from taking
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THE WHOS OF SURET Y BONDS
WHO NEEDS THEM?
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A few professionals that almost always
require surety bonds:
Auto dealers
Real
estate brokers
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Construction companies
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Collection agencies
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Durable
medical
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equipment providers
Health clubs
Auctioneers
Travel agencies
These three parties in a surety guarantee:
Principal – person or entity required
to post bond
Obligee – government entity or person
requiring principal to be bonded
Surety – provides financial guarantee to
obligee on behalf of principal
part in fraud and other unethical business
practices,” explains Danielle Rodabaugh,
director of education at SuretyBonds.com.
“Most commercial bonds are license and
permit bonds – which are required before
government agencies issue a license or
permit. Their purpose is usually to
safeguard the public and keep the
government from losing money.”
There are thousands of different types of
commercial bonds that surety companies
offer. Among the most frequently purchased
are contractor’s license bonds, tax preparer
bonds, notary bonds, and judicial and
fiduciary bonds such as probate bonds.
The difference between surety
and insurance
When a business obtains a surety bond,
it pays a fraction of the whole sum of a
surety bond to the surety bond company.
Payment ranges from 1% to 3% of the
bond amount for well-qualified applicants,
all the way up to 25% for applicants
with less-than-stellar credit or limited
financial history.
If the principal fails to fulfill the bond’s
obligations, the harmed party can make
an indemnity claim. If the claim is valid, the
surety will provide compensation up to the
bond amount.
A bank line of credit is generally secured
with equipment or other assets such as
real estate. Surety, however, is typically
supported in an indemnity agreement
stating the bonded company will reimburse
the surety for any and all losses and costs.
Underwriting surety bonds
Bonded principals must therefore take
every action possible to avoid claims.
“The surety is only extending you credit,
and therefore will expect to be reimbursed
if a valid claim is paid,” stressed Victor J.
Lance, president of Lance Surety Bond
Associates. “Having a paid surety claim
may make it very difficult for the principal
to become bonded again in the future,
as it is a standard question on all bond
applications, and is usually a cause for
declination.”
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Just as surety is more like banking than
insurance, surety underwriting is more
financially driven than other insurance
classes. “It’s underwritten very similarly to
what a bank would go through to extend a
line of credit,” Krumm says.
For smaller clients such as a family held
construction company, surety writers take
a very hands-on underwriting approach
underscored by a through vetting of the
“Three C’s of Surety”: character, capital
and capacity.
Publicly traded Fortune 1000 companies
seeking surety bonds require quite a
different underwriting approach. “While
the financial strength of the company may
not be at issue, a key difference may be
understanding various uses of surety,”
Krumm says. “A great example would be
using a surety bond in lieu of a letter of
credit – something more readily supported
by surety in recent years.”
“With the market moving out of a recession and
beginning to grow more steadily, the right carrier
can help producers provide effective surety
solutions for their clients,” Thomas says.
Reclamation bonds are among the most
difficult to place. They guarantee restoration of land to its original condition after
an extractive industry – such as mining,
oil or natural-gas development – scars the
landscape. They’re required by the Bureau
of Land Management and various state
environmental agencies.
Market update
These bonds represent long-term surety
obligations that generally cannot be
canceled; adequate performance can
be highly subjective and bond losses,
if incurred, can be large.
Surety experts agree business is trending
upward in their sector.
Specifically, as the real estate sector
continues to recover, “We have seen a
robust uptick from regional and national
FA S T FAC T S
$5 billion
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Annual premium in the
surety bond market
Major Surety Carriers
• The Hanover
• ACE Group
• American Contractors Insurance Group
•Chubb
•CNA
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2013 surety
underwriting profit
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• HCC insurance Holdings
• International Fidelity Insurance Company
• Liberty Mutual
• The Hartford
•Travelers
THE BASIC FOURS
Contract surety bonds:
• Bid bond
• Performance bond
• Payment bond
• Maintenance bond
Commercial surety bonds:
• License and permit bonds
• Court bonds
• Fiduciary or probate bonds
• Public official bonds
homebuilders for new subdivision bonds,”
said Robert F. Thomas, president of
Hanover Surety.
Thomas predicts upcoming regulatory
changes for bonds required in the oil
and gas sectors will also result in a higher
demand for surety in challenged sectors
that are struggling with low fuel prices.
The recent growth of the bonding industry
means there’s now a significant premium
base. It’s about $5 billion annually in the
US, and also growing in overseas markets.
On the flip side, there’s also increased
competition for that premium. There are
new entrants into the marketplace,
capacity is plentiful and inevitably, price
wars have started.
Meanwhile, the ample capacity means
surety brokers typically will be able to find
a home for most opportunities.
Great opportunities
Thomas sees tremendous opportunity for
producers to sell value by establishing
surety lines of credit for their clients.
“For qualified businesses, a surety line of
credit through an independent agent often
is a much better alternative than working
with a bank,” he says.
Great opportunities exist for producers
when it comes to partnering with the right
surety insurance carriers.
“With the market moving out of a recession
and beginning to grow more steadily, the
right carrier can help producers provide
effective surety solutions for their clients,”
Thomas says.